Digital Cash and the Regulators

by J. Orlin Grabbe

Digital cash, like other forms of money, can be issued
in any political or legal jurisdiction, or in any banking
environment: Salt Lake City, the Cayman Islands, Cyprus,
or Sidney. There is a great deal of flexibility available
to the digital cash provider when viewed from a global
perspective.

Nevertheless, digital cash may operate locally under
a set of rules and regulations similar to other forms
of computer money such as bank deposits. (Locally
can be almost any Internet-accessible country.) The
question of how banking regulators view digital cash
is a practical one, because the answers to the question
demonstrate the sort of issues that arise in any banking
context. All the examples here will involve the U.S.,
a country with a complex maze of banking regulations.

From the point of view of central bankers, digital cash
generates three sorts of questions. Who issues it?
How is it used as a means of payment? What impact
does it have on the banking system balance sheet or
bottom-line?

Currency Competition and Seigniorage

Digital cash is by design a partial substitute for ordinary
cash. Hence it will be used in much the same fashion
as ordinary cash--a context with which central bankers
are familiar. To a certain extent, digital cash threatens
the profitability inherent in central bank note issue.

Consider travelers checks. Travelers checks are a
form of private bank currency. They are analogous
to the bank notes issued by private commercial banks
in the U.S. prior to the Civil War. As such, they
are very profitable to the banks and companies that
issue them, because no interest is paid out on travelers
checks to the check holders, but the issuer earns interest
on the funds that customers use to purchase them.
When you purchase American Express Travelers Checks,
you are making an interest-free loan to American Express.
Thats why AMEX likes to sell them to you--apart from
the fees involved in the transaction.

As with travelers checks, digital cash products such
as electronic purses (a card with a memory chip on
it) represent an attempt by commercial banks to capture
part of the seigniorage earned by the
central bank from issuing notes. Holders of currency
(Federal Reserve notes) are making an interest-free
loan to the government. The interest opportunity cost
adds up. The approximate $20 billion that the Federal
Reserve turned over to the U.S. Treasury in 1994, for
example, represented about 5 percent of the $400 billion
in Federal Reserve notes.

The Bank for International Settlements (BIS) estimated
that in the United States seigniorage is .43 percent
of gross domestic product (GDP), while central bank
(Federal Reserve) expenses are .03 percent of GDP,
implying a profit of .40 percent of GDP. [1]

These numbers can be used as a reference base to calculate
the amount of seigniorage recapture available to providers
of digital cash. Suppose that that digital cash was
so successful for small purchases that it eliminated
the U.S. $1, $5, $10, and $20 dollar bills. In that
case, the BIS estimates the loss in seigniorage at
.14 percent of GDP. Now it is highly unlikely that
digital cash would replace all small denomination bills,
as assumed in this calculation. But the calculation
shows that up to one-third of current Federal Reserve
seigniorage is potentially available to digital cash
providers. And thats a lot of money.

While some central banks may be concerned that digital
cash will infringe on their monopoly of issuing bank
notes (although most do not appear to be particularly
alarmed), such a monopoly can be easily circumvented
without computers and without telecommunications. All
that is required for the success of any privately-issued
currency is local acceptance as a means of payment
for goods and labor. Consider, for example, HOURS,
which is a local currency circulating in Ithaca, New
York. Here is a brief (albeit dated) summary of the
HOURS system. [2]

HOURS is a local currency created and issued by citizens
in Ithaca, New York. The organizers have issued over
$50,000 in local paper money to over 950 participants
since 1991. An estimated $500,000 of in HOURS-based
transactions have taken place.

The idea behind an HOUR is that it is a rough equivalent
to a $10.00 bill. The unit was chosen because ten
dollars per hour was the average wage paid in Tompkins
County. HOUR notes come in four denominations, and
have been used to buy goods and services like plumbing,
carpentry, electrical work, roofing, nursing, chiropractic
care, child care, car and bike repair, food, eyeglasses,
firewood, and gifts. The local credit union accepts
them for mortgage and loan fees. People pay rent
with HOURS. Some of the best restaurants in town take
them, as do movie theaters, bowling alleys, two large
locally-owned grocery stores, and thirty farmer's market
vendors.

Everyone who agrees to accept HOURS is paid two HOURS
($20.00) for being listed in the newsletter Ithaca
Money. Every eight months they may apply to be
paid an additional two HOURS, as reward for continuing
participation. This mechanism increases the per capita
supply of HOURS. Ithaca Money contains 1200
member listings. HOUR loans are made without interest
charges.

Multi-colored HOURS bear serial numbers and are printed
on hard-to-counterfeit locally-made watermarked cattail
(marsh reed) paper. Naturally, HOUR payments are taxable
income when received for professional goods or services.

The organizers have created a guide to creating local
currency, called a Hometown Money Starter Kit. The
Kit explains the start-up and maintenance of an HOURS
system, and includes forms, laws, articles, procedures,
insights, samples of Ithaca's HOURS, and issues of
Ithaca Money. Theyve sent the Kit to over 300 communities
in 45 states. To get one, send $25.00 (or 2.5 HOURS)
to Ithaca Money, Box 6578, Ithaca, NY. 14851.

HOURS, much like travelers checks, are an attempt to
recapture a part of the currency seignoriage usually
given up to the central bank. Like HOURS, digital cash
does not require the approval of some central authority
to form a viable mechanism. And the presence of seigniorage
means that digital cash products can be highly profitable,
for they simply arbitrage the difference between the
cost of producing digital cash and the return available
to the issuers of the medium of exchange. As we saw
previously, the Federal Reserve made $20 billion of
this arbitrage in 1994, after payment of all expenses.

Is Digital Cash (Stored-Value)
a Deposit?

U.S. banking regulations distinguish broadly between
deposit-issuing institutions and others. Thus the question
whether the digital cash liability of a private company
represents a deposit or not determines who might attempt
to regulate it or whether it is eligible for federal
deposit insurance.

Some of these questions here are more important in a
non-anonymous digital cash system than in an anonymous
one. A depositor who is anonymous, or who wishes his
transactions to remain private, is probably not interested
in being identified for insurance purposes, or receiving
regular bank statements detailing his financial activities.
But, that having been said, a look at some representative
regulations is important for the purpose of understanding
the political and legal barriers to the creation of
an anonymous digital cash system.

Digital cash is a balance sheet liability of the commercial
banks or companies that issue it. Does it thus fall
under the laws governing ordinary checking accounts?
And what about discharge of debt? In the case of the
U.S., federal law does not currently address obligations
discharged by stored value cards--only those settled
by cash, check, or wire transfer.

FDIC deposit insurance, which applies to most bank deposits,
can be easily extended to stored value cards under
the guise of a general liability account. The FDIC
General Counsel has issued an opinion [3] that divides
stored-value cards into four categories:

· Bank Primary-Customer
Account Systems--where funds stay in the customers
account until they are transferred to a merchant or
other payee (as with a debit card). These are considered
customer deposits and covered by FDIC deposit insurance.

· Bank Primary-Reserve Account
Systems--where funds are downloaded onto a customers
card (or software), and the banks obligation is transferred
to a reserve or general liability account to pay merchants
and other payees. These are also considered issuer
deposits, and covered by FDIC insurance.

· Bank Secondary-Advance
Systems--where a card issuer is a third party, the
bank makes the cards available to customers, and customers
pay the third party for the stored value using funds
from their bank account. The stored-value funds in
this case are not considered deposits, and are not
covered.

· Bank Secondary-Pre-Acquisition
Systems--where the card is issued by a third party,
the bank pays the third party for the card value, and
subsequently sells the stored value to customers.
Again, the stored-value funds are not considered deposits,
and are not covered.

Non-banks, meanwhile, are not eligible for FDIC
deposit insurance. But the question remains, If non-banks
issue stored-value products, are these stored-value
funds deposits? For if stored-value is legally a
deposit, then federal and state regulators might attempt
to deny a company or other entity the right to issue
the product, using the Glass-Steagall Act or similar
provisions.

If stored value-products are deposits, then
a non-bank might also become subject to the jurisdiction
of the Federal Trade Commission (12 U.S.C.A. 1831 t(e))
or might be treated as a bank for the purposes of the
Bank Holding Company Act (12 U.S.C.A. 1841 (c)(1)).
This is something to keep in mind before selecting
Salt Lake City as your digital cash base.

Nationally chartered banks are under the supervision
of the Office of Comptroller of the Currency (OCC).
The OCC has explicitly approved national bank participation
in one digital cash system, Mondex, and in stored value
systems generally, stating national banks may under
12 U.S.C. 24(Seventh) engage in the business of Mondex
USA, and also that national banks may under 12 U.S.C.
24(Seventh) engage in the business of operating a stored
value system. [4]

In addition, the Federal Reserve has authorized bank-holding
companies who own ATM networks to provide stored-value
card systems through these networks.

A Closer Look at Mondex

Mondex is known as a stored value card system. Stored
value simply means the money is stored on a memory
chip on the Mondex card instead of, say, being stored
as pieces of paper in your wallet. This stored value
will be used in everyday purchase and sale transactions
just like cash. Hence the chief function of the stored
value is as a medium of exchange (and not, as the
name might imply, as intertemporal savings--which is
the usual meaning of the phrase store of value in
economic discussions of money).

The rights to Mondex are held by Mondex International
Ltd., a U.K. limited liability company. Fifty-one percent
of Mondex International is owned by MasterCard International,
while a consortium of global banks owns the other 49
percent. The U.S. rights to Mondex have been purchased
by a group of nationally-chartered U.S. banks, listed
below.

These U.S. banks have in turn formed two Delaware limited
liability companies to operate Mondex. One of these
two companies will act as a bank. It will create,
sell, and redeem the electronically stored value
(ESV) on Mondex cards. That is, it will trade other
forms of U.S. dollars for value stored on the Mondex
card. It will issue (sell) ESV for dollars,
and it will redeem (buy back) ESV in exchange
for dollars. ESV is thus just another form of money:
dollars, if denominated in dollars; pounds, if denominated
in pounds, and so on. From now on we will simply call
the Mondex ESV Mondex Dollars.

The Delaware company acting as the bank is called an
OLLC (Originator Limited Liability Company). Its liabilities
will be the Mondex Dollars it issues against payment.
The money the OLLC receives will be invested in U.S.
government securities, and cash and cash-equivalents
such as interbank deposits and overnight repurchase
agreements. These are the OLLC assets. The holdings
of cash and cash-equivalents is required in order to
be able redeem Mondex Dollars on demand.

The second Delaware company will act as a licensing
and servicing entity. The equity in the two companies
is divided up between Wells Fargo (30 percent), Texas
Commerce Bank (20 percent), First National Bank of
Chicago (10 percent), AT&T (10 percent), NOVUS (10
percent), and MasterCard (10 percent).

In granting these nationally-chartered banks the right
to operate a subsidiary which carries out digital cash
operations, the OCC applied four criteria: (1) Is
the operation related to banking? (2) Do the banks
have sufficient control to disallow non-banking activities?
(3) Is the banks loss exposure limited? (4) Is the
investment related to the banks ordinary banking business?
Since the OCC determined that the answers to these
four questions were all yes, it approved the Mondex
proposal.

Regulation E

The Federal Reserves Regulation E implements the Electronic
Fund Transfer Act (EFTA). Under the guise of consumer
protection, Regulation E requires various disclosures
related to electronic funds transfer, as well as advance
notice of changes in terms, transaction receipts, periodic
statements, error resolution procedures, limitations
on consumer liability, and restrictions on unsolicited
giving of funds-transfer access-devices to consumers.
On May 2, 1996, the Federal Reserve proposed to extend
Regulation E to stored value cards. It would classify
stored-value systems as on-line, off-line accountable,
or off-line unaccountable.

On-line systems would be simple debit cards where
accounts balances are stored in a central database,
not on the card, and communication with the central
facility is required for balance transfers. Off-line
accountable systems are ones in which balances
are recorded on the card, transactions do not have
to be transmitted to a central facility to be pre-authorized,
but where each transaction is stored and periodically
transmitted to a central facility. Off-line unaccountable
systems are those in which transactions are not
pre-authorized, transactions are not traceable to a
particular card, and the cards value is only recorded
on the card itself.

The Fed proposes to make both on-line and off-line
accountable systems subject to Regulation E requirements
on transaction receipts and dispute resolutions if
the maximum value that can be loaded is greater than
$100, but exempt if the maximum value is $100 or less.
Off-line unaccountable systems allowing values
greater than $100 would be subject to the Regulation
E requirement on initial disclosure, but would be totally
exempt with respect to payment transactions. On-line
systems allowing values greater than $100 would have
to meet all requirements of Regulation E, except for
periodic statements, provided an account balance and
account history is available on request.

The Feds proposal would thus seem to eliminate on-line
anonymous systems (because of the transaction history
requirement), but would allow for off-line anonymous
systems under the off-line unaccountable option--as
long as account withdrawals were recorded.

A digital cash system like Mondex, operating out of
Delaware, has to grapple with all these issues. This
has the advantage that, having made the regulators
happy, the Mondex owners can then aggressively market
their product through all the usual banking and financial
channels.

Those who are looking to create a digital cash product
where privacy and security are paramount will probably
want to go off-shore and avoid the regulators to a
great extent. But they will still be left with the
more important, and practical, problem of making their
customers happy. And they will still be looking to
recapture some of the central bank seigniorage.

* * *

[1] Bank for International Settlements, Implications
for Central Banks of the Development of Electronic
Money, Basle, October 1996.

[2] Glover, Paul, Creating Ecological Economics with
Local Currency, undated manuscript. Glovers article
contains a lot of grass-roots socialism that I dont
agree with. But that is not material to the use of
HOURS as an illustration of an alternative currency.